Anthony Rayner: The fiscal wave is coming

We have thought for some time that extreme monetary policy is looking increasingly tired. There has undoubtedly been a positive impact on financial markets, though there are concerns that this is reaching its limits. Meanwhile, the feed-through to the real economy has been disappointing and the consequences for areas like inequality are adding to the list of negatives, never mind the longer term concerns around capital misallocation.

However, it's important to remember that the background to arriving at this point has been through a number of individual and fairly rational decisions - even if they look much less rational in accumulation. Since the mid-1980s most major economies have not experienced an inflationary threat. As a result, central banks moved their focus to economic growth or, more accurately, extending the economic cycle.

On that measure central banks have been pretty successful, evidenced by the US economy currently enjoying its longest economic expansion since records began and, still, with minimal inflation. Let's also not forget that businesses, politicians and the public, generally, have been pretty supportive of this shift in focus.

That said, it's looking like an increasingly narrow definition of success. One negative consequence of quantitative easing (QE) that is less talked about is that the behaviour of financial markets is playing an elevated role in deciding economic growth outcomes.

To be sure, central banks have always paid some attention to financial markets in their modelling, for example through consideration of the "wealth effect", but financial markets are increasingly seen as an extended policy tool, and less an objective judge of the health of companies and economies.

Central banks are happy to admit in private that they are in a bit of a pickle: attempts to exit QE have eventually led to elevated levels of market stress but, at the same time, it is increasingly clear that every time central banks intervene again, or reverse their exit, so the sensitivity of economies to financial markets increases. However, their desire not to panic the markets means their public plea is diluted down to a request to governments for some help with the heavy lifting - but this is growing louder by the day.

In reality, the most likely outcome is a change in the policy mix, rather than extreme monetary policy disappearing. The benefits of fiscal spending are that it will have a more direct impact on the real economy, borrowing costs are low and infrastructure deficits are widely acknowledged in countries like the UK, Germany and the US. There are also risks, such as spending being directed for largely political reasons, rather than for the benefit of society, or to improve economic productivity.

There are obstacles too. One is a dogmatic attachment to austerity and another is the complexity of political decision making (compared with central banks for example). Investing in green infrastructure or in response to the coronavirus help save political face and hurdle the first obstacle easily enough.

However, remaining at the top of the list of political priorities for long enough is still a challenge, though there are increasing signs that there is a shift in policy, not just via tax cuts, but also through increased government spending in a number of countries.

What might be the life jacket for financial markets if we start to get a material increase in government spending? It might be that fiscal policy, assuming it is successful, turns financial markets on their head, driving economic growth and inflation higher, taking cyclical equity and bond yields higher too.

Indeed, the main question has to be, in a period of reflation, what will happen to US government bonds, the core safe haven that anchors many multi-asset portfolios and influences assets across the spectrum? 

History shows that the combination of material government spending and government bond markets doesn't make for a particularly happy marriage, though extreme monetary policy might serve to hold yields down. Gold is worth considering too: in the past provided some protection against inflationary risk, as well as exhibiting safe haven characteristics.

Anthony Rayner is a fund manager at Premier Miton Investors

This article appeared in the April issue of Professional Adviser's bi-monthly sister title Multi-Asset Review. To make sure you receive your own copy of the next issue, please register your interest here

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